Am I an Employee or Founder???
"The difference between a founder and an early employee is gray, not black and white."
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published April 23, 2013. Updated August 3, 2023 and November 1, 2023.
Quora Question:
Why do startups have an exponential drop-off in equity for employees? I've never heard a reasonable explanation of why there should be exponential drop-off in equity compensation based on joining time in a startup (vs. linear, for example). Obviously you need some time function to push prospective employees to make the jump when they are earning below-market salary, but is there a good reason why the drop-off is often exponential?
November 2023 Update: Great info on this point for technical co-founders / early employees from YC in this video called How Not to Get Screwed Over as a Software Engineer.
Stock Option Counsel Answer:
The Gray Area -- Revealed!
This is a great question because it reveals a truth: The difference between a founder and an early employee is gray, not black and white. There is not a true difference that would allow an exponential difference to be appropriate.
A Thinking Trick
It is very useful for an employee to reverse the exponential drop logic the company may use -- how much more than zero should this "employee" receive -- to acknowledge the gray area by thinking along the lines of "How much less than a founder should I receive?" While it is unlikely for an employee to come in at close to founder level, that should be ideal starting point to work from in your mental calculation of what is appropriate and will inspire you to perform at a founder level.
Founder Delusions
And remember that founders are notoriously delusional about how soon they will be funded, so don't drink the Kool-Aid. I see companies try to grant employee-level equity before a funding on the promise that they are "just about to be funded." They promise salaries that will be "deferred" until funding and try to bring on "first employees." If you're not getting paid a startup-phase-market-level salary today, you are not at an employee's level of risk. Be sure you are granted founder-level equity if you have founder-level risk.
Data Sets
Data sets on employee and executive offer percentages for early stage startups can be misleading and encourage companies to make unrealistically low offers to early hires. There’s two reasons for this. First, these data sets are for employees who are earning something like market level salaries along with equity. Second, these data sets exclude anyone classified as a “founder” from the data set for employees. They keep different data sets for founders! So the gray area between the two classifications makes the use of data tricky. Who is a founder for purposes of the data set? Depends on the data set. Carta, for instance, excludes anyone with 5% or more from the employee/executive data set and classifies them as founders! Even if they are earning market-level cash from their start date.
How to Think About This
Here’s the bottom line:
If you are joining before you are being paid startup-phase-market-level cash salary, you are a late stage founder. You should evaluate your equity percentage relative to the other founders within the company or within the market data set.
If you are joining for a combination of cash and equity at an early stage startup, the offer should make sense to you. Simply pointing to market data for the right % ownership is not enough. You’ll want to consider the market data for % ownership in conjunction with the dollar value of the equity based on how investors have most recently valued the company.
More here.
Link to Quora Q&A: https://www.quora.com/Startups/Why-do-startups-have-an-exponential-drop-off-in-equity-for-employees .
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 1: Why You Need a Startup Stock Option Exercise Strategy
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Andrea Piacquadio.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to Exercise Stock Options?
Startup stock options can be extremely lucrative or extremely disappointing. The biggest disappointments are not from companies that never succeed, but from employees of successful companies that are not able to take advanteBefore you accept a startup stock option offer, you will want to have a strategy in place for exercising those options. This up-front attention will save you from the unhappy but common surprises associated with startup stock options, such as these recent examples:
Forfeiture at Termination. Sales executive drove sales and company value for four years and was terminated a few months before a $1B company exit. He could not afford the $1M exercise cost (to cover the exercise price and tax cost of exercise) within the 30-day post-termination exercise deadline, so he was forced to forfeit most of his vested options. He made approximately $500K at the exit; his former colleagues with similar equity grants made $10M.
Golden Handcuffs. Early hire at a future unicorn did not early exercise his startup stock options or exercise as they vested. He wanted to leave the company after four years when he was fully vested, but he could not afford the $2M cost to cover the exercise price and tax cost of exercise. Therefore, he had to stay at the company for 3 more years while he waited for an acquisition, frustrated that he was not able to move onto his next opportunity.
Tax Expense. Early hire at a future public company waited to exercise his options with a total exercise price of $5,000 until after the shares became publicly traded. He had to sell the shares on the same day as the exercise to cover the tax expense of exercise. Since he had not held the shares for a year before sale, his gains were taxed at ordinary income tax rates of over 40%. If he had early exercised the options, he would have qualified for QSBS tax treatment on his gains, resulting in 0% federal tax rates and saving him >$1M in taxes.
In the Part 2, you will see the menu for startup stock option exercise strategies to save yourself from these unhappy surprises. In Part 3, you will see a Q&A on FAQs re stock option exercise strategies.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 2 - Examples of a Clawback Clause for Startup Stock
Working for a startup? Learn how a clawback clause, forfeiture term or repurchase right limits the value of startup equity. Plan ahead to protect your equity stake.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
What is a Clawback Clause?
Startup hires expect that they will be able to keep their vested shares if they leave the company before an exit event. That’s not always the case. Learn more in Part 1 of this series - Clawbacks for Startup Stock - Can I Keep What I Think I Own - about how a clawback clause limits the value of startup equity.
In this post, we will share some examples of a clawback clauses or clawback provision that would allow startups to take back vested shares or options.
What is an Example of a Clawback Clause?
Equity Incentive Plan I
The company reserves the right to include clawbacks for vested shares upon an individual's termination of employment:
Repurchase Right. The Company (and other designated Persons) may repurchase any or all of the shares of Stock granted to a Participant pursuant to an Award or acquired by the Participant pursuant to the exercise of a Stock Option upon such Participant’s termination of employment with, or Service to, the Company for any reason to the extent such a right is provided in an Award Agreement or other applicable agreement between the Company and the Participant.
Such terms could be included in any agreement with the individual, such as a Stock Option Grant Notice, a Stock Option Agreement, a Stock Option Exercise Agreement, a Termination and Release or Severance Agreement, a Restricted Stock Agreement, an RSU Agreement, an Employment or IP Agreement, or a Stockholders' Agreement.
Equity Incentive Plan II
The company reserves the right to implement a policy in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Clawback Policy. The Awards granted under this Plan are subject to the terms of the Corporation’s recoupment, clawback or similar policy as it may be in effect from time to time, as well as any similar provisions of applicable law, any of which could in certain circumstances require repayment or forfeiture of Awards or any shares of Common Stock or other cash or property received with respect to the Awards (including any value received from a disposition of the shares acquired upon payment of the Awards).
Stock Option Agreement
The company reserves the right to change its bylaws in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Right of Repurchase. To the extent provided in the Company’s bylaws in effect at such time the Company elects to exercise its right, the Company will have the right to repurchase all or any part of the shares of Common Stock you acquire pursuant to the exercise of your option.
These two terms allowing retroactive changes push the limits of Delaware law on company repurchase rights. However, I advise my clients to negotiate these out of their documents before joining a company to avoid litigation at a later date.
Restricted Stock Unit Grant Notice
In order to vest RSUs, the time-based vesting requirement (the "Time Condition") must be met, and the Company must have an IPO or a Change of Control (the "Performance Vesting") prior to the 7 year expiration period of the RSU. This is a normal structure for a startup RSU grant due to tax planning. However, in this example, if the IPO or Change of Control does not occur by the individual's last date of employment, the RSUs are cancelled and never vest:
Vesting Conditions. Any Restricted Stock Units that have satisfied the Time Condition as of such date shall remain subject to the Performance Vesting set forth in Section 2(b) above, but shall expire and be of no further force or effect on the first to occur of (a) the date on which the Grantee’s Service Relationship with the Company terminates, or (b) the Expiration Date.
Employment and Confidentiality Agreement
The company reserves the right to terminate vested options in the event of a breach of the agreement:
Breach of Confidentiality Agreement. If the Optionee breaches the provisions of the Confidentiality Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested and unvested Option Shares.
Breach of Non-Competition and Non-Solicitation Covenant. If the Optionee breaches the Non-Competition and Non-Solicitation Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested or unvested Option Shares.
While these two examples from employment and confidentiality agreements apply to restrictions on exercising options, similar terms may also apply to repurchase or forfeiture of vested shares for violations of such agreements even after termination of employment. More on this here from the National Association of Stock Plan Professionals in June 2023.
Other Clawback Clauses
These are only a few examples of how clawbacks might appear in an equity offer. There are more ways they can appear in the fine print. And, practically, an option exercise deadline acts as a clawback as well. Having only 3 months to exercise options is a standard market term, but it often acts to prevent employees and executives from exercising their vested shares. More on this in:
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Thank you!
Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Clawback Clause for Startup Stock - Can I Keep What I think I Own?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Updated October 19, 2020 for a recent clawback event in the news.
Everyone loves a gold rush story about startup hires making millions on startup equity. But not all startup equity is created equal. If a startup adds a repurchase rights for vested shares (a.k.a. a clawback clause or clawback provision) to its agreements, individuals may lose the value of their vested equity because a company can force them to sell their shares back to the company in certain situations, such as if they leave their jobs or are fired prior to IPO or acquisition. Other examples of a clawback clause are forfeiture (rather than repurchase) of vested shares or options at termination of employment or for violation of IP agreements or non-competes.
Image from Babak Nivi of Venture Hacks, who warns startup founders and hires to “run screaming from” startup offers with a clawback clause for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”
How a Clawback Clause Limits Startup Equity Value
In a true startup equity plan, executives and employees earn shares, which they continue to own when they leave the company. There are special rules about vesting and requirements for exercising options, but once the shares are earned (and options exercised), these stockholders have true ownership rights.
But for startups with a clawback clause, individuals earn shares they don’t really own. In the case of repurchase rights for vested shares, the company can purchase the shares upon certain events, most commonly after the individual leaves or is terminated by the company. If the individual is still at the company at the time of an IPO or acquisition, they get the full value of the shares. If not, the company can buy back the shares at a discounted price, called the “fair market value” of the common stock (“FMV”) on the date of termination of employment or other triggering event.
Most hires do not know about the clawback clause when they negotiate an offer, join a company or exercise their stock options. This means they are earning equity and purchasing shares but do not have a true sense of its value or their ownership rights (or lack thereof).
Clawback Clause “Horrible” for Employees - Sam Altman of Y Combinator
In some cases a stockholder would be happy to sell their shares back to the company. But repurchase rights are not designed with the individual’s interests in mind. They allow the company to buy the shares back against the stockholder’s will and at a discounted price per share known as the “fair market value” or “FMV” of the common stock. As Sam Altman (now CEO of OpenAI) wrote when he was the head of Y Combinator, “It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this.”
The FMV paid by the company for the shares is not the true value for two reasons. First, the true value of common stock is close to the preferred stock price per share (the price that is paid by investors for stock and which is used to define the valuation of the startup), but the buyback FMV is far lower than this valuation. Second, the real value of owning startup stock comes at the exit event - IPO or acquisition. This early buyback prevents the stockholder realizing that growth or “pop” in value.
What is an Example of a Clawback Clause?
Famous Example - Skype Shares Worth $0 in $8.5 Billion Acquisition by Microsoft
In 2011, when Microsoft bought Skype for $8.5 billion (that’s a B), some former employees and executives were outraged when they found that their equity was worth $0 because of a clawback in their equity documents. Their shock followed a period of disbelief, during which they insisted that they owned the shares. They couldn’t lose something they owned, right?
One former employee who received $0 in the acquisition said that while the fine print of the legal documents did set forth this company right, he was not aware of it when he joined. “I would have never gone to work there had I known,” he told Bloomberg. According to Bloomberg, “The only mention that the company had the right to buy if he left in less than five years came in a single sentence toward the end of the document that referred him to yet another document, which he never bothered to read.”
Both Skype and the investors who implemented the clawbacks, Silver Lake Partners, were called out in the press as “evil,” the startup community’s indignation did not change the legal status of the employees and executives who were cut out of millions of dollars of value in the deal.
Recent Example - Tanium, funded by Salesforce Ventures and Andreessen Horowitz, claws back employee shares
More recently, Business Insider reported that Tanium, funded by Salesforce Ventures and Andreessen Horowitz, has forced employees to sell their shares back to the company at FMV after their employment is terminated.
The employees interviewed by Business Insider were not aware of that their contract included this clawback when they accepted their offers. “'Surprised' was my initial reaction," one such employee said. "I had not heard of that happening before. To me it felt like a gut punch. One of the reasons for working for the company is dangling the carrot of eventually going public or eventually getting acquired so employees would monetarily benefit from that.”
How Does a Clawback Provision Work?
Hypothetical Example #1 - Company Does NOT Have Clawback Clause for Vested Shares - Share Value: $1.7 Million
Here’s an example of how an individual would earn the value of startup stock without repurchase rights or clawbacks. In the case of an early hire of Ruckus Wireless, Inc., the value would have grown as shown below.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million. If you want to see the working calculations, see this Google Sheet.
These calculations were estimated from company public filings with the State of California, the State of Delaware, and the Securities and Exchange Commission. For more on these calculations, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO.
Hypothetical Example #2 - Company Has Clawback Clause for Vested Shares - Share Value: $68,916
If the company had the right to repurchase the shares at FMV at the individual’s departure, and they left after four years of service when the shares were fully vested, the forced buyout price would have been $68,916 (estimated). This would have caused the stockholder to forfeit $1,635,054 in value.
In this hypothetical, the individual would have lost $1,635,054 in value if the shares were repurchased at their termination. If you want to see the working calculations, see this Google Sheet.
No Surprises - Identifying a Clawback Clause During Negotiation
As you can see, clawbacks dramatically affect the value of startup stock. For some clients, this term is a deal breaker when they are negotiating a startup offer. For others, it makes cash compensation more important in their negotiation. Either way, it’s essential to know about this term when evaluating and negotiating an offer, or in considering the value of equity after joining a startup.
Unfortunately this term is not likely to be spelled out in an offer letter. It can appear in any number of documents such as stock option agreements, stockholders agreements, bylaws, IP agreements or non-compete agreements. These are not usually offered to a recruit before they sign the offer letter and joining the company. But they can be requested and reviewed during the negotiation stage to discover and renegotiate clawbacks and other red-flag terms.
What is a Typical Clawback Clause?
For examples of typical clawback clause language, see Part 2 - Examples of Clawbacks for Startup Stock.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
VIDEO: Founder Restricted Stock Purchase Agreements
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Are you a founder with a restricted stock purchase agreement (RSPA)? Protect your equity stake with change of control vesting acceleration, Section 83(b) election and fine print details.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.